Sat 5 Nov 2005
Penny stocks have enjoyed a large increase in popularity recently. However, for those unfamiliar with penny stocks this may seem like a high risk activity that no responsible trader would engage in. This is not necessarily true. It’s clear that large institutional traders who run mutual finds are not allowed to trade penny stocks due to minimum price restrictions amongst other things. This is often transmitted to the average investor as a warning to stay away from pennies. However, its simple to see that if institutional traders can’t trade them, then you will definitely not find any institutional traders giving buy recommendations on one. So, lets take a moment to investigate further.
The SEC defines any stock trading at under 5 dollars as a penny stock. Some traders however, only consider stocks trading at under 1 dollar as a true penny stock. Most stocks that trade on either the OTCBB or the Pink Sheets are also considered penny stocks.
Many services will warn investors to avoid penny stocks. They cite reasons such as the fact that companies on the OTCBB do not have financial disclosure and reporting requirements. Specifically, companies who’s stocks are listed as OTCBB stocks will have a “,OB” after their symbol. These stocks are part of an electronic trading system run by the National Association of Security Dealers (NASD). One of the main problems with a lot of OTCBB stocks is that they are not required to report certain financial statements and disclosures as for example, a NASDAQ listed stock would be required to. Another problem often encountered with OTCBB stocks is lack of liquidity. This means that if you buy one of these stocks, you may find it difficult to sell in a hurry. A stock priced in the 1 cent range could trade millions of shares a day. However, considering that 1 million shares of a stock priced at .0001 cent only costs 100 dollars, one can see that just a few trades per day can make it seem as if a penny stock is very liquid. One must ensure to adjust their volume expectations when dealing with penny stocks.
Are there penny stocks out there that meet the liquidity criteria of traders who would like to mitigate risk by feeling comfortable that they can exit a position at any time? The answer is yes. The OTCBB is gaining popularity with traders at a staggering rate. In 1994 the OTCBB traded the equivalent of just 4.5% of what the NASDAQ traded. In 2003 this number went up to 68% of what the NASDAQ has traded in share volume.
So, why the appeal? Well if we go back to our 1 million share example, we can see that if a buyer picks up 1 million shares of a stock trading at .0001 for 100 dollars and then sells it at .005, they have taken a 100 dollar investment and turned it into 5 thousand dollars. How common is this type of activity? Not all that uncommon, and many traders are taking advantage of this high potential for large multiples on your money.
Are penny stocks for everyone? Probably not. If you don’t have the time to keep an eye on your positions, it may not be the right trading vehicle for you, and just as with any other trading activity, due diligence is required. However, if you put in the time to do the research, then pennies may be just the ticket for outsized profits.
SMG Staff